Assume that the creditor has a security interest with respect to all $1.2 million of the borrower’s assets. Its secured claim—which is the lesser of the amount owed and the value of the collateral—would thus be $1 million. Under a 75 % fixed-fraction priority rule, the creditor will receive $750,000 of the encumbered assets. The remainder of its claim, $250,000, would be made unsecured and pooled with those of the other two creditors. The $450,000 in assets available to pay unsecured claims would then be distributed to the three creditors in proportion to their unsecured claims so that the $2.25 million in unsecured claims ($2 million in claims by the adjusting and nonadjusting creditors and $.25 million of the secured creditor’s secured claim which is rendered unsecured by operation of the rule) would be paid 20 cents on the dollar. Thus, the secured creditor would receive $50,000 for its unsecured claim and the other creditors would receive $200,000 each. http://www.easyloans-now.com/
As we explain in The Uneasy Case, the fixed-fraction priority rule would reduce the ability of creditors and their commercial borrowers to use security interests to transfer value from nonadjusting creditors by not allowing secured claims to fully subordinate nonadjusting claims in bankruptcy. The fixed-fraction priority rule would thus also decrease the excessive use of security interests, the distortion in monitoring arrangements that commercial borrowers and their creditors adopt, and (as we will explore in more detail below), the funding of undesirable business activities. The reduction of these distortions would depend on the percentage of the secured claim that is treated as unsecured: the larger the percentage, the greater the reduction in the identified efficiency costs. In the extreme case where the entire secured claim is treated as unsecured, the parties could not use a security interest to transfer value in bankruptcy, and the inefficiencies that full priority causes would be completely eliminated.